This is the second post in a series discussing the pitfalls of annuities, specifically variable annuities. Regulators and the media have given increased attention to these products in recent years, as more cases have surfaced showing they have been sold to people who were unaware of the terms and risks involved.
Risk. A fixed annuity pays a fixed, and stated, rate of return throughout the annuity term, and so is likely invested in very safe, low-return investments. A variable annuity, by contrast, is usually invested in mutual funds or other products that have a higher return but are definitely riskier. While there is certainly a place for higher-return investments as part of an overall financial planning strategy, this could be disastrous if a substantial portion of your retirement savings – money you can’t afford to lose – is parked there. Take a hard look at the underlying investments for any annuity. A sales rep will emphasize attractive returns, but don’t stop there. Find out where, exactly, your money will be invested. Will it be invested in mutual funds based on untested industries or uncertain emerging markets? Will it be invested in high-risk, high-return “junk” bonds?
Death Benefit. Variable annuities often feature a death benefit that guarantees your heirs will receive the full value of the annuity in the event of your death, even if the annuity has lost value. This may sound like a good deal, but it isn’t free. Usually, there is a charge, perhaps one or two percent per year, for this benefit. That doesn’t sound like much, but calculate what this percentage means in real dollars, and then compare this amount to going rates for life insurance. You might be able to buy a life insurance policy outright for the same amount or less, providing exactly the same benefit to your heirs.
Hefty Fees. Variable annuities have notoriously high fees. Why? Because everyone involved needs to make their money. The mutual funds underlying your investment have fees, and those fees have to be passed on to you. The insurance companies want to cover their costs – particularly the commissions they pay on the sale of variable annuities – and so they pass on fees to you, as well. Unless you’re earning above-average returns that cover all of these fees, you would almost assuredly be better off investing your money outright and managing it yourself.
Other than keeping a large sum of money that you could spend too quickly out of your hands, most of what a variable annuity offers could be done on your own. Consider any variable annuity with a skeptical eye.
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